1. Chapter 6 Funding the Public Sector

2. Introduction
During the past few years, federal government spending has increased at the same time that revenues collected from taxes and other sources have declined. To cover its expenditures, the federal government has resorted to borrowing.
As you will learn in this chapter, however, the government budget constraint indicates that ultimately spending and revenues must be equalized.

3. Learning Objectives
Distinguish between average tax rates and marginal tax rates
Explain the structure of the U.S. income tax system
Understand the key factors influencing the relationship between tax rates and the tax revenues governments collect

4. Learning Objectives (cont'd)
Explain how the taxes governments levy on purchases of goods and services affect market prices and equilibrium quantities

5. Chapter Outline Paying for the Public Sector Systems of Taxation
The Most Important Federal Taxes
Tax Rates and Tax Revenues
Taxation from the Point of View of Producers and Consumers

6. Did You Know That ...
More than a dozen U.S. states have sold bonds promising annual payments based on projected revenues from a legal settlement with the tobacco industry?
To obtain the funds required to finance their operations, state and local governments collect taxes from many different sources such as property tax, sales tax, income tax, and hotel occupancy tax.
At the federal level, there are Social Security taxes, Medicare taxes, and income taxes.

7. Paying for the Public Sector
Three sources of government funding
Fees for government services, or user charges
Taxes
Borrowing

8. Paying for the Public Sector (cont'd)
Government Budget Constraint
The limit on government spending and transfer payments
Imposed by the fact that every dollar spent must be provided for by taxes

9. Example: State Tuition Rates Jump – Even at the Last Moment
To continue operations with limited budgets during the recession of the late 2000s, more than half of the states have cut spending on higher education.
In turn, state universities have responded by raising tuition.
At a number of state universities, tuition rates have increased as late as the final course registration date.

10. Systems of Taxation Tax Base Tax Rate
The value of goods, services, wealth, or incomes subject to taxation
Tax Rate
The proportion of a tax base that must be paid to a government as taxes

11. Policy Example: Is It Time to Replace Gasoline Taxes with Mileage Taxes?
Taxes on gasoline are a major source of funds for road construction and repair.
Yet, with more battery-powered vehicles on the road, the gasoline tax base has been shrinking.
The Congressional Budget Office has suggested using a mileage tax base.
Vehicle owners would be taxed based on the number of miles driven, as recorded by a mileage meter on the vehicle.

12. Systems of Taxation (cont'd)
Marginal Tax Rate
The change in the tax payment divided by the change in income
Marginal tax rate =
change in taxes due
change in taxable income

13. Systems of Taxation (cont'd)
Tax Bracket
A specified interval of income to which a specific and unique marginal tax rate is applied
Average Tax Rate
The total tax payment divided by total income

14. Systems of Taxation (cont'd)
Proportional Taxation
A tax system in which, regardless of an individual’s income, the tax bill comprises exactly the same proportion
Taxpayers at all income levels pay the same percentage of their income in taxes

15. Systems of Taxation (cont'd)
Proportional taxation
Marginal tax rate = Average tax rate
Income Tax Rate Taxes
$10, % $2,000
$100, % $20,000

16. Systems of Taxation (cont'd)
Progressive Taxation
A tax system in which, as income increases, a higher percentage of the additional income is paid as taxes

17. Systems of Taxation (cont'd)
Progressive taxation
Marginal tax rate > Average tax rate
Income Tax Rate Taxes
$0–$10, % $500
$10,001–$20, % $1,000
$20,001–$30, % $3,000

18. Policy Example: Calculating the Top U.S. Marginal Tax Rate
In the progressive tax system of the federal government and most states, the highest income earners pay the highest overall tax rates.
The highest U.S. income earners are able to keep for their own use just over half of the last dollar they earn.

19. Systems of Taxation (cont'd)
Regressive Taxation
A tax system in which as more dollars are earned, the percentage of tax paid on them falls
A smaller percentage of income is taken in taxes as income increases

20. Systems of Taxation (cont'd)
Regressive taxation: Social Security*
Marginal tax rate < Average tax rate
Income Tax Rate Taxes
$100, % $10,000
$200,000 5% $10,000
* No social security tax after $100,000 in income

21. The Most Important Federal Taxes
Question
What types of taxes do federal, state and local governments collect?
Answers
Federal government: individual income taxes, corporate income taxes, Social Security taxes, import and excise taxes
State and local governments: sales taxes, property taxes, personal and corporate income taxes

22. Figure 6-1 Sources of Government Tax Receipts
Source: Economic Report of the President, Economic Indicators

23. The Most Important Federal Taxes
The federal personal income tax
Accounts for almost 44% of all federal revenue
All U.S. citizens, resident aliens, and most others required to pay (includes income earned abroad)
Rates paid rise as income increases

24. Table 6-1 Federal Marginal Income Tax Rates

25. The Most Important Federal Taxes (cont'd)
Arguments for the progressive tax
Redistribution of income
Ability to pay
Benefits received
Counterargument
No strong evidence of redistribution

26. Policy Example: Figuring Out How Much to Pay In Income Taxes Is Not Cheap
The Internal Revenue Service has estimated that U.S. taxpayers spend nearly $200 billion per year to determine how much they owe in income taxes.
In addition, taxpayers devote 7.6 billion hours to this process.
Using an opportunity cost of $16 per hour, this amounts to a total cost of roughly $325 billion per year.

27. The Most Important Federal Taxes (cont'd)
Capital Gain
The positive difference between the purchase price and the sale price of an asset
You buy a share of stock for $5 and sell for $15: you have a capital gain of $10
Capital Loss
The negative difference between the purchase price and the sale price of an asset

28. The Most Important Federal Taxes (cont'd)
The corporate income tax
Accounts for 12% of federal tax revenue and 2% of all state and local taxes collected
Corporations are generally taxed on the difference between total revenues and expenses

29. Table 6-2 Federal Corporate Income Tax Schedule

30. The Most Important Federal Taxes (cont'd)
Double taxation
Corporation pays taxes on its profits
Corporation declares a dividend on after-tax profits
Dividend income is taxed

31. The Most Important Federal Taxes (cont'd)
Retained Earnings
Earnings that a corporation saves, or retains, for investment in other productive activities
Earnings that are not distributed to stockholders
Tax Incidence
The distribution of tax burdens among various groups in society

32. The Most Important Federal Taxes (cont'd)
Who really pays the corporate income tax?
Tax incidence is distributed among
Consumers
Stockholders
Employees

33. The Most Important Federal Taxes (cont'd)
Social Security taxes
Social Security rates today are imposed on earnings up to roughly $106,800
Contributions are 6.2% for employers and 6.2% for employees

34. The Most Important Federal Taxes (cont'd)
Unemployment taxes
Paid by employer
0.8% of first $7,000 of wages for employees earning more than $1,500
States may levy an additional tax up to 3% based on record of the employer

35. Tax Rates and Tax Revenues
State and local governments
Taxes imposed on goods and services yield more revenues than income taxes
A fundamental issue is how to set tax rates to extract the largest possible payments

36. Tax Rates and Tax Revenues (cont'd)
Sales Taxes
Taxes assessed on the prices paid on a large set of goods and services
Ad Valorem Taxation
Assessing taxes by charging a tax rate equal to a fraction of the market price of each unit purchased

37. Policy Example: States Seek to Apply Sales Taxes to Internet Retailers’ Sales
In an attempt to increase tax revenues, some states have targeted Internet retailers who are linked to other sellers, known as affiliates, who have a physical presence within the state.
Whenever state governments have tried to tax these retailers, the affiliate programs have been eliminated.
Thus, these states have not succeeded in expanding their sales tax base.

38. Tax Rates and Tax Revenues (cont'd)
Static Tax Analysis
Based on the assumption that changes in the tax rate leave the tax base unaffected
Dynamic Tax Analysis
Recognizes that higher tax rates may shrink the tax base

39. What If . . . The government seeks to collect higher taxes by increasing capital gains tax rates?
When people learn about upcoming increases in the capital gains tax rate, they can attempt to sell their assets immediately.
Alternatively, asset sales can be postponed if the tax rate is expected to fall.
Indeed, there is considerable evidence of an inverse relationship between capital gains tax rates and realized capital gains.

40. Tax Rates and Tax Revenues (cont'd)
If the disincentive effects of higher tax rates are small, static analysis may give a fairly accurate estimate of the change in tax revenues resulting from a tax rate change
As tax rates escalate, members of the public have a greater incentive to remove their activities from the tax base; a dynamic analysis would be necessary to determine the overall effect on government revenues

41. Figure 6-2 States with the Highest and Lowest Sales Tax Rates

42. Tax Rates and Tax Revenues (cont'd)
Maximizing tax revenues
Dynamic tax analysis predicts ever-higher tax rates bring about declines in the tax base
At sufficiently high rates the government’s tax revenues begin to fall off

43. Figure 6-3 Maximizing the Government’s Sales Tax Revenues

44. Taxation from the Point of View of Producers and Consumers
Excise Tax
A tax levied on purchases of a particular good or service
Unit Tax
A constant tax assessed on each unit of a good that consumers purchase

45. Taxation from the Point of View of Producers and Consumers (cont'd)
Excise taxes on gasoline become added costs of production
This shifts the supply curve up by the amount of the unit tax
Consequently, the equilibrium price of gasoline rises and the equilibrium quantity declines

46. Figure 6-4 The Effects of Excise Taxes on the Market Supply and Equilibrium Price and Quantity of Gasoline

47. Taxation from the Point of View of Producers and Consumers (cont'd)
Who Pays the Tax?
In our example, the price that each consumer pays is $0.30 per gallon higher
Therefore, consumers pay three-fourths of the excise tax and producers absorb the remainder

48. You Are There: How to Keep Social Security in Business
Nancy Altman is co-director of Social Security Works, a group dedicated to preserving the Social Security programs that provide benefits to the elderly and disabled.
Altman proposes two ways of preserving both programs:
1) Combine both programs, so that tax dollars originally intended to provide benefits for the elderly would be diverted to disability benefits
2) Increase the Social Security tax rate

49. Issues & Applications: What Determines the U. S
Issues & Applications: What Determines the U.S. Long-Run Average Tax Rate?
Figure 6-5 on the next slide displays the average U.S. federal tax rate for each year since 1934.
Since the early 1950s, this overall average tax rate has ranged between 15 and 21 percent.
The greater instability of the average individual income tax rate reflects both changes in marginal tax rates and variations in the amount of income subject to taxation.
The current ratio of federal spending to national income of about 24 percent is well above the overall tax rate of 15 percent.

50. Figure 6-5 The Overall Average Federal Tax Rate and Its Components and Federal Spending as a Percentage of National Income

51. Summary Discussion of Learning Objectives
Average tax rates versus marginal tax rates
Average tax rate is the ratio of total tax payments to total income
Marginal tax rate is the change in tax payments, induced by a change in total taxable income: applies to the last dollar earned

52. Summary Discussion of Learning Objectives (cont'd)
The U.S. income tax system taxes personal and business income
A tax system is progressive when marginal tax rate increases as income rises
Contrasts with regressive system, in which higher-income earners pay lower marginal tax rates
Under proportional taxation, the marginal and average rate are equal

53. Summary Discussion of Learning Objectives (cont'd)
The relationship between tax rates and tax revenues
Static tax analysis assumes that the tax base does not respond significantly to an increase in the tax rate
Dynamic tax analysis reveals how an increase in the tax rate causes the tax base to decline

54. Summary Discussion of Learning Objectives (cont'd)
How taxes on purchases of goods and services affect market prices and quantities
A tax collected from the seller of a good will shift the supply curve up
To the extent that the price rises, consumers pay a portion of the tax and sellers pay the remainder